5 C’s of Credit
5 C’s of Credit
In early times, the lack of financial institutions and absence of banks resulted in the exploitation of poor by the greedy financiers. Borrowers can only escape from the clutches of loan sharks if they have easy access to efficient credit networks. Moreover, credit network is also required so that the savers can deposit their money in reliable financial intuitions so that it can be channelized from the rich people to the poor industrialists (Ferguson, 2008). The primary relationship that money defines is between a lender and a borrower. This relationship is based on the underlying credibility of the borrower to repay the money on a timely basis. Although the money symbolizes mutual trust, Fergusons describes in his book how the Spaniards failed historically that the value of money is not absolute (Ferguson, 2008). Moreover, due to the great importance is given to the trust between borrower and lender, the credit markets in today era has developed standards that both the parties could use when valuing money to be used as a loan.
Every prospective lender, a bank or a development corporation, seeks to review the creditworthiness of a borrower before they entertain the credit request. A well-documented loan request assists the lender in understanding the purpose of the loan and the business of the borrower. The “five C’s” are the primary elements used for the credit analysis.
Capacity: Capacity is the ability of the business or an individual to repay the loan. When forwarding a loan to the privately owned business, the financial institution reviews the past and forecasted financial statements and determines whether or not the forecasts are in harmony with the historical financial performance and business plans. It also evaluates whether the forecast shows that enough post expense cash flows will be available to repay the debt (5 C’s of Credit Analysis, 2016).
Capital: Capital refers to the investment of the owner in the business (Amolm, 2016). It tells the lender whether or not the owner is taking on the sufficient risk of failure. Capital does not include only equity and loans, but also include other sources such as outside equity, and subordinated debts, donations, and grants. Capital assists the business to rely on during times when the cash flow is tight due to recession or unstable economy. Moreover, lenders also like to ensure that the owners to remain dedicated to the business in the period of difficulties invest sufficient capital.
Collateral: Collaterals, also referred to as guarantees, are the additional securities provided to the lender. It helps the lender in determining that if the financial performance of the privately owned business didn’t go as planned, how they will repay the loan. The business pledges their assets, such as property or equipment, to the lender as a guarantee in case if the business is unable the repay the loan. It is different than guarantee as in it only a document is signed by the person to repay the loan in case of inability of the business to do so.
Conditions: There are two aspects of conditions. First, it is the overall external business environment and economic conditions in which financial institutions and private business are operating. When the economy is going through the period of recession, it becomes difficult for the small private companies to repay the loan in a timely manner and even more difficult for the banks to finance the loans. In these circumstances, it is very important that company presents a strong application of the bank to reduce the chances of rejection.
Secondly, conditions also refer to the desired purpose of the loan. The financial institution needs to know where the company will use the money and whether the purpose is appropriate financially or not. For instance, whether the money will be used for the purchase of new equipment? Or whether it will be used in working capital to meet the seasonal inventory requirement?
Character: Character refers to the general impression of the company on the lender. The lenders usually make a subjective judgment on whether or not the borrowing company is trustworthy enough to repay the loan in a timely manner or produce a return on finance invested by the lender. In doing so, the lender considers the historical financial performance and industry creditworthiness of the company. If the company has a credit rating, it is also considered (Abrahams, 2010).
The lending practices of major financial institutions indicate that while evaluating the credit, the main focus of financial institutions is to the capacity of the private businesses to repay the loan and the character of the company (Corporation, 2006). The primary reason behind this is the increasing cases of frauds, such as Enron case, and uncollectible debts. Collateral is given the secondary importance, and it is also considered as the necessary element before forwarding loan of any size (Corporation, 2006).
In today’s dynamic business era, access to the business loans and credits has become increasingly challenging. The case is more critical in case of private companies as they lack the credibility enjoyed by public companies. Therefore, it requires that the private companies should be more aware of the rules and financial standards required by financial institutions. However, private companies should not forget that financial institutions are always willing to assist them in achieving their goals and create success by implementing the feasible financial strategy. Therefore, an iron-clad application by the company can create a big difference and could be of great importance in obtaining credit.
References
5 C’s of Credit Analysis. (2016). Retrieved from http://www.mbda.gov/blogger/financial-education/5-c-s-credit-analysis
Abrahams, C. (2010). Closing the Gap between Credit Access and Risk Management. Retrieved from http://support.sas.com/resources/papers/proceedings10/351-2010.pdf
Amolm. (2016). The 5 C's of Credit. Retrieved from https://www.nerdwallet.com/blog/5-cs-credit/
Corporation, T. I. (2006, December). Emerging Collateral Practices in Countries with Reformed and Unreformed Secured Transactions Frameworks. Retrieved from http://www.supersociedades.gov.co/web/Comision/entrega4/Collateral%20Lending%20to%20SMEs%20Final.pdf
Ferguson, N. (2008). The Ascent of Money. New York: The Penguin Press.
